Chapter 12 Depository Institutions: Banks and Bank Management Conceptual and Analytical Problems Explain how a bank manager uses Core Principles 1, 2 and 3 (Time Has Value, Risk Requires Compensation, and Information Is the Basis for Decisions) to select assets and issue liabilities consistent with shareholder preferences. Answer: The manager evaluates the return and risk of each asset and liability, as in core principles 1 and 2, prior to adding it to the balance sheet. These evaluations usually require collection and processing of information, as in core principle 3. On the asset side, for example, does the interest rate on auto loans provide sufficient compensation for the risk of default? To make this judgment, the loan officer must collect and process information to judge whether prospective borrowers are able and willing to repay. On the liability side, will the interest rate offered on certificates of deposit attract funds sufficient to support the bank’s assets? The risk and return of the overall balance sheet also should be evaluated according to the owners’ risk preferences. For example, risk-averse shareholders may wish the manager to hold a relatively large proportion of government securities and a relatively low proportion of loans. Consider a bank with the following balance sheet. You read in the local newspaper that the bank’s return on assets (ROA) was 1 percent. What were the bank’s after-tax profits?
Bank Balance Sheet
(in thousands)
Assets Liabilities
Reserves $100 Deposits $1,000
Loans $500 Borrowing $0
Securities $500 Bank Capital $100
Answer: Since the return on assets is defined as , with ROA reported as 0.01 and assets of $1.1 million, after-tax net profit would be ROA × (Bank assets) = 0.01 × ($1,100,000) = $11,000 . Based on the information provided below about banks A and B, compute for each bank its return on assets (ROA), return on equity (ROE) and leverage ratio. Bank A has net profit after taxes of $1.8 million and the balance sheet below:
Bank A (in millions)
Assets Liabilities
Reserves $5 Deposits $100
Loans $70 Borrowing $10
Securities $45 Bank Capital $10
Bank B has net profit after taxes of $0.9 million and the balance sheet below:
Bank B (in millions)
Assets Liabilities
Reserves $7.5 Deposits $75.0
Loans $55.0 Borrowing $3.0
Securities $23.5 Bank Capital $8.0
4. Answer: For both banks, we will compute ROA as and ROE as As a check, we note that where is the leverage ratio, the value of assets divided by the owner’s equity. a. Bank A has net profit after taxes of $1.8 million. Given assets of $120 million, its ROA was (1.8 / 120) = .015 or 1.5%. Since bank capital is $10 million, its ROE is (1.8 / 10) = .18 or 18%. Its leverage ratio is (120 / 10) = 12. As a check, we should find that: ROA × (leverage factor) = ROE In this case, with ROA of 1.5% and leverage of 12, ROE of 18% is correct. b. Bank B had net profit after taxes of $0.9 million. Its ROA is (0.9 / 86) = .0105 or 1.05%; its ROE is (0.9 / 8) = .1125 or 11.25%; and its leverage ratio is (86 / 8) = 10.75. Banks hold more liquid assets than do most businesses. Explain why. Answer: Banks are required to meet depositors’ demands for cash. In order to be able to do this, they need to hold assets that are relatively liquid. Most businesses do not need to be able to come up with cash on short notice, so they do not need to hold as many liquid assets. Explain why banks’ holdings of cash have increased significantly as a portion of their balance sheets in recent times. Answer: Banks hold cash for liquidity purposes - to meet immediate withdrawal requests from customers. Holding cash is costly for banks, however, due to the interest foregone on holding alternative assets. With the onset of the financial crisis, banks dramatically increased their cash holdings, as the possibility of bank runs rose and other assets became less liquid. Falling interest rates also reduced the opportunity cost of holding cash. Moreover, in October 2008, the Federal Reserve began paying interest on bank reserves (one type of cash asset), further reducing the opportunity cost of holding cash in this form. Why are checking accounts not an important source of funds for commercial banks in the United States? Answer: Financial innovation has reduced the importance of checkable deposits in the day-to-day business of banking. The reason for their decline is that checking accounts pay little to no interest; they are a low-cost source of funds for banks but a low-return investment for depositors. As interest rates rose through the 1970s and remained high into the 1990s, individuals and businesses realized the benefits of reducing the balances in their checking accounts and began to look for ways to earn higher interest rates. Banks obliged by offering innovative accounts whose balances could be shifted automatically when the customers’ checking accounts ran low. The volume of commercial and industrial loans made by banks has declined over the past few decades, while the volume of real estate loans has risen. Explain why this trend occurred and how it contributed to banks’ difficulties during the financial crisis of 2007-2009. Answer: The rise of the commercial paper market enabled businesses to raise funds directly, diminishing their need to borrow from banks. The creation of mortgage-backed securities meant that banks did not have to hold the relatively illiquid mortgage loans they originated on their balance sheets. However, banks purchased a large amount of these mortgage-backed securities (MBS accounted for about one half of banks’ securities holdings in January 2010) and so suffered a significant decline in the value of their assets when MBS prices plummeted. Why do you think that U.S. banks are prohibited from holding equity as part of their own portfolios? Answer: If a bank owns equity in a company to which it extends a loan, the fact that it is a part owner of the company can give rise to a conflict of interest. If the company were to run into trouble with the loan, the bank may be tempted to treat that company differently. Any perceived financial trouble for the company may reduce the value of its stock and so adversely impact the value of the bank’s equity investment. Explain how a bank uses liability management to respond to a deposit outflow. Why do banks prefer liability management to asset management? Answer: Banks can respond to a deposit outflow by borrowing from another bank or from the Federal Reserve or by issuing large-denomination time deposits. During the financial crisis of 2007-2009, banks found it difficult to raise funds through many of the usual channels and the Federal Reserve introduced additional lending programs to help banks manage their liquidity. Banks prefer liability management to asset management because asset management shrinks the size of a bank’s balance sheet, while liability management does not. A bank with a two-year horizon has issued a one-year certificate of deposit for $50 million at an interest rate of 2 percent. With the proceeds, the bank has purchased a two-year Treasury note that pays 4 percent interest. What risk does the bank face in entering into these transactions? What would happen if all interest rates were to rise by 1 percent? Answer: The bank faces the risk that the short-term interest rate will rise before the second year, increasing the amount of interest the bank has to pay on the CD, but leaving the interest income that the bank receives from the Treasury note unchanged. With an interest rate of 2 percent for the CD and 4 percent for the Treasury note, the bank’s annual interest income is (.04) × $50 million = $2 million and the bank’s annual interest expenses are (.02) × $50 million = $1 million. The bank makes a profit of $2 million – $1 million = $1 million. If the interest rate rises 1 percent, the bank’s profit falls to ((.04) × $50 million) – ((.03) × $50 million) = $500,000. In response to changes in banking legislation, the past two decades have seen a significant increase in interstate branching by banks in the United States. How do you think a development of this type would affect the level of risk in banking business? Answer: The increase in interstate branching increases the ability of banks to diversify their loans across different geographic areas and often different industries. This would reduce the credit risk banks face. Consider the balance sheets of Bank A and Bank B. If reserve requirements were 10 percent of transaction deposits and both banks had equal access to the interbank market and funds from the Federal Reserve, which bank do you think faces the greatest liquidity risk? Explain your answer.
Answer: On the basis of the information given, Bank B is at greater risk. The liability sides of the balance sheets are the same, so the analysis should focus on the asset side. Bank A has a higher level of excess reserves and is therefore better able to meet unexpected withdrawals by depositors. In addition, Bank A has a higher level of securities which are generally more liquid than loans. Bank A could sell these securities in the market place if funds were needed immediately. Looking again at Bank A and Bank B in Problem 12, based on the information available, which bank do you think is at the greatest risk of insolvency? What other information might you use to assess the risk of insolvency of these banks? Answer: Bank A has net worth (bank capital) of $320 million while Bank B has net worth of $100 million. Bank A has more of a cushion against interest rate movements and so on the basis of the information available Bank B runs the greater risk of insolvency. More information on the interest-rate sensitivity of the assets and liabilities of the two banks would be helpful in further assessing their insolvency risk as would information on each bank’s off-balance sheet commitments. Bank Y and Bank Z both have assets of $1 billion. The return on assets for both banks is the same. Bank Y has liabilities of $800 million while Bank Z’s liabilities are $900 million. In which bank would you prefer to hold an equity stake? Explain your choice. Answer: Your choice will depend on your preference for return versus risk. If the two banks have $1 billion in assets and have the same return on assets, then net profit after taxes must be the same for both banks. Bank Y has bank or equity capital of $200 million while Bank Z has equity capital of $100 million, so the return on equity is higher for Bank Z. Bank Z has a higher leverage ratio than Bank Y, however, as a higher portion of its assets is financed from borrowed funds. Therefore, Bank Z represents a riskier investment. You are a bank manager and have been approached by a swap dealer about participating in fixed for floating interest-rate swaps. If your bank has the typical maturity structure, which side of the swap might you be interested in paying and which side would you want to receive? Answer: A typical bank has liabilities that are shorter-term than its assets – or has floating rate liabilities and fixed rate assets. Because the bank receives fixed interest payments and has to make floating interest payments, it is at risk when interest rates rise. To hedge against this risk, the bank should pay fixed and receive floating in the interest rate swap. That way, when interest rates rise, the receipts from the swap will increase to offset the higher rates the bank must pay its depositors. If lines of credit and other off-balance sheet activities do not, by definition, appear on the bank’s balance sheet, how can they influence the level of liquidity risk to which the bank is exposed? Answer: With lines of credit, customers pay a fee to the bank for the right to borrow at their behest. It is the customer, not the bank that determines when the loan is made and becomes an asset on the bank’s balance sheet. The bank is obligated to honor its commitment whenever the customer requests the loan and will need to finance that loan regardless of its liquidity situation at that point in time. This increases the liquidity risk faced by the bank. Suppose a bank faces a gap of -20 between its interest-sensitive assets and its interest-sensitive liabilities. What would happen to bank profits if interest rates were to fall by 1 percentage point? You should report your answer in terms of the change in profit per $100 in assets. Answer: A gap of -20 means that the bank has more interest-sensitive liabilities than assets. When interest rates fall, therefore, its profits will rise as it gains more on paying less on its liabilities than it loses in receiving less on its assets. The gap of -20 implies that profits will rise by 20 cents per $100 of assets. Duration analysis is an alternative to gap analysis for measuring interest-rate risk. (See footnote 9 on page 316.) The duration of an asset or liability measures how sensitive its market value is to a change in the interest rate: the more sensitive, the longer the duration. In Chapter 6, you saw that the longer the term of a bond, the larger the price change for a given change in the interest rate.
Using this information and the knowledge that interest rates increases tend to hurt banks, would you say that the average duration of a bank’s assets is longer or shorter than that of its liabilities? Answer: When interest rates increase, the market value of assets such as bonds fall. If interest rate increases hurt banks, then the average value of assets must fall by more than the average value of liabilities. Given that duration is a measure of the sensitivity of the market value to a change in interest rates, this implies that the average duration of bank assets is longer than that of its liabilities. Suppose you were the manager of a bank with the following balance sheet.
Bank Balance Sheet
(in millions)
Assets Liabilities
Reserves $30 Checkable Deposits $200
Securities $150 Time Deposits $600
Loans $820 Borrowings $100
You are required to hold 10 percent of checkable deposits as reserves. If you were faced with unexpected withdrawals of $30 million from time deposits, would you rather: Draw down $10 million of excess reserves and borrow $20 million from other banks? Draw down $10 million of excess reserves and sell securities of $20 million? Explain your choice. Answer: Option (a) is preferable to option (b) because it doesn’t shrink the size of the balance sheet. In normal market conditions, banks would prefer not to reduce the size of their balance sheets as that lowers their profits. Suppose you are advising a bank on the management of its balance sheet. In light of the financial crisis of 2007-2009, what arguments might you make to convince the bank to hold additional capital? Answer: The financial crisis of 2007-2009 resulted in projected losses of nearly $1 trillion in US bank assets. In the absence of substantial government support, many banks would have become insolvent. Holding sufficient capital (the difference between the value of a bank’s assets and liabilities) is crucial for maintaining the bank’s solvency. While holding capital is costly, there is a trade-off between securing the solvency of the bank and that cost. The financial crisis compelled banks to reduce their leverage sharply. Consider the following two views of the balance sheet of a bank before and after the financial crisis. Which balance sheet view is more likely to be that of the bank after the financial crisis? Support your choice with calculations. Bank Balance Sheet – View 1
(in millions)
Assets Liabilities
Reserves $30 Deposits $800
Securities $150 Other Borrowed Funds $90
Loans $820 Bank Capital $110
Bank Balance Sheet View 2
(in millions)
Assets Liabilities
Reserves $30 Deposits $800
Securities $150 Other Borrowed Funds $110
Loans $820 Bank Capital $90
Answer: We can calculate the leverage ratio for each of the views: Leverage Ratio = Total Assets / Bank Capital. For View 1, we get 1,000/110 = 9.09 For View 2, we get 1,000/90 = 11.1 If banks reduced their leverage after the crisis, it is more likely that View 1 represents the post-crisis balance sheet. Note, you could also calculate the leverage ratio as Debt / Equity + 1. For View 1, we get 890/110 = 8.09 + 1 = 9.09 For View 2, we get 910/90 = 10.1 + 1 = 11.1 After a protracted period of historically low interest rates in the wake of the financial crisis, many observers predicted that the Federal Reserve would follow its December 2015 rate tightening with a series of further interest rate increases. Based on gap analysis, would this scenario be more likely to hurt or help your bank’s profitability, assuming your bank’s liabilities are more interest sensitive than its assets? What steps might your bank take to prepare for this scenario? Answer: Given your bank has a negative gap—i.e. more interest sensitive liabilities than assets, it is more likely that a series of interest rate hikes would hurt profits. This is because the additional interest the bank would have to pay on its interest sensitive liabilities would be greater than the additional interest it would earn on its assets. The bank could try to reduce the gap between the interest sensitivity of its assets and liabilities as this would lessen the impact on profits, everything else being equal. The bank also could engage in hedging activities to manage this interest rate risk, such as engaging in interest rate swaps. Data Exploration Are U.S. banks increasing in size? Use FRED to plot since 1984 on a quarterly basis the number of U.S. commercial banks (FRED code: USNUM) and, on the right scale, the volume of their deposits (FRED code: DPSACBM027SBOG). Download the data and compute the average deposit size of banks in the first quarters of 1984 and 2016. Do these sizes accurately portray a typical commercial bank? Answer: The data plot is: Using quarterly data, at the beginning of 1984, there were 14,400 commercial banks and deposits of $1,489 billion, resulting in an average deposit level of about $104 million. In the first quarter of 2016, the number of banks had fallen to 5,260 while deposits had risen to $11,030 billion, yielding an average deposit level of $2,097 million. However, most banks are much smaller than the average suggests. The ratio of deposits in the relatively small number of large domestically chartered commercial banks (FRED code: DPSLCBM027SBOG) to deposits in all domestically chartered commercial banks (FRED code: DPSDCBM027SBOG) was nearly 60% in early 2016. Similarly, as of 2014, the five largest U.S. banks held about 48 percent of bank assets (see World Bank, 5-Bank Asset Concentration for United States; FRED code DDOI06USA156NWDB). Commercial banks have become increasingly involved in the real estate market. Plot the percent change from a year ago of real estate loans made by commercial banks (FRED code: REALLN) and discuss the relationship between the booms and busts in real estate lending and the expansions and recessions of the U.S. economy. Answer: The cycles in real estate lending, plotted below, appear to coincide closely with business expansions and recessions. Real estate lending often grows strongly in expansions and slows prior to and during recessions. Figure 12.1 shows that commercial banks increased their exposure to real estate over several decades, so the unanticipated downturn in housing prices after 2006 exposed the commercial banking sector to substantial risk. As of mid-2016, real estate loans were growing at about a 7 percent rate, consistent with a recovery from the housing plunge during the Great Recession of 2007-2009. Plot since 1990 the return on equity of small banks (banks with assets of less than $1 billion; FRED code: US1ROE) and large banks (banks with assets of greater than $15 billion; FRED code: USG15ROE). How do you explain the long-run pattern? Answer: As shown below, the return on equity for small banks is usually, but not always, lower than for large banks. It also appears a bit less volatile. One possibility is that larger banks bear more risk (possibly through greater leverage), so the plot reflects Core Principle 2 (risk requires compensation). Another possibility is that larger banks benefit from economies of scale. Banks sometimes manage liquidity risk by issuing large, marketable certificates of deposit when other deposits decline. How important is this practice? Plot the share of large time deposits (FRED code: LTDACBM027SBOG) in total deposits (FRED code: DPSACBM027SBOG). Explain how this share evolved over the long run and after 2004. Answer: The plot below shows that bank borrowing in the “wholesale” money market has been cyclical. Since 2004, the importance of attracting large deposits peaked prior to the financial crisis and then plummeted. Part of the post-crisis decline reflects bank efforts to deleverage (and reduce their balance sheets). In addition, risk-averse investors may have preferred Treasury debt to a bank deposit, while near-zero interest rates may have encouraged others to seek higher returns in other financial instruments. What share of U.S. banks fail? Plot since 2000 the fraction (in percent) of bank failures (FRED code: BKFTTLA641N) relative to the number of banks (FRED code: USNUM). Comment on the timing and the proportion of failures. Were most of the failing banks large or small? Answer: The plot below shows that bank failures in the United States rose with a lag as the Great Recession proceeded and peaked after the recovery began. Moreover, failures remained elevated (compared to the pre-recession period) for years after the recovery began. The largest banks are few in number and several were supported during the financial crisis by the injection of additional capital from taxpayers (through the U.S. Treasury). So, most (but not all) of the failing banks were relatively small institutions that did not pose a threat to the financial system when they failed. indicates more difficult problems. Solution Manual for Money, Banking and Financial Markets Stephen G. Cecchetti, Kermit L. Schoenholtz 9781259746741, 9780078021749, 9780077473075
